Viewpoint: Keep Boards in Check With Public Directors

As President Obama recognized in his recent remarks at Federal Hall, the necessity of federal bailouts one year ago is damning evidence of how utterly broken our financial system has become. Yet while passive internal oversight by the boards of directors across the financial sector was one of the chief factors in the crisis, a shocking 92% of the directors of the top 17 firms receiving taxpayer support from the Troubled Asset Relief Program have remained in office.

An ambitious agenda of government regulation will do little to avoid another crisis if directors are asleep at the wheel. Boards of directors are given the responsibility for overseeing management decisions and protecting the value of the firm for shareholders. This role was designed to provide a private system of checks and balances. Today, that system is badly damaged.

That is why, in conjunction with the Center for American Progress, I have authored a paper proposing the special appointments of public directors to the boards of companies that receive large infusions of taxpayer support to survive.

Public directors will first and foremost provide a voice representing the interests of the taxpayer. But, if implemented judiciously, a system of outside, skeptical, public directors can also serve to curb some of the problems with corporate governance.

Excessive executive compensation has been one of the most prominent pieces of evidence of the breakdown in board oversight over financial firms. When New York Attorney General Andrew Cuomo evaluated the bonuses of nine banks that received taxpayer rescues during the crisis, he found that taxpayers were taken for a ride. Banks — with the approval of their boards — paid out $32.6 billion in bonuses in 2008, even while receiving $175 billion in taxpayer support.

The Bank of America-Merrill Lynch merger stands out as another example of the failures of board oversight.

The Securities and Exchange Commission reached a $33 million settlement with B of A over its allegations that the company misled investors about bonuses and losses at Merrill Lynch before the merger. A federal judge rejected the settlement, saying it "does not comport with the most elementary notions of justice and morality."

It was predictable that there would be a inquiry into who knew what and when among B of A's directors, who approved the merger. Cuomo has now subpoenaed five of the directors, seeking information about their knowledge of the disclosure of the fourth-quarter losses at Merrill Lynch.

At the April annual B of A shareholders meeting, organized shareholder activists stripped CEO Kenneth Lewis of his position as board chairman, and vigorously contested the re-election bid of lead director, Temple Sloan, who resigned the next month. But while these outcomes may have satisfied the bloodlust of angry investors, shareholder activism is generally a slow and uncertain method for restoring the checks and balances of internal corporate decision-making. Only the most highly visible judgments will be subject to the organized campaigns needed to dislodge a somnolent board, and then typically only with overwhelming shareholder support.

Our elected officials have an obligation to ensure that taxpayer dollars are being stewarded effectively, and yet this has not been the case when it has come to the financial bailouts. That is why I am proposing the installation of public representatives on the boards of corporations that receive significant public funds. When the federal government steps up as the "investor of last resort" it should demand measures to ensure accountability and transparency, just as any private investor would.

To ensure that these public directors operate efficiently and in the best interests of the taxpayer, two principles should be applied: proportionality and diversity of experience and ideas.

Proportionality means that if the federal government invests in 30% of a company's shares, it ought to receive roughly 30% representation on that company's board. The government may need additional legislative authority to realize this principle, something that could perhaps be included in any expanded resolution authority received by the bank regulators.

Diversity of ideas and experience should be a basis upon which public directors should be selected. Too often in this crisis, we have seen the boards of financial institutions rubber-stamp questionable moves that boards with a less insular worldview might have rejected. The economist Scott Page argues persuasively that "diverse groups of problem solvers — groups of people with diverse tools — consistently outperformed groups of the best and brightest … a board of directors is not a mob or a crowd, but it too benefits from diversity."

These modest changes will not eliminate bad judgments and executives who take excessive compensation. But they can help to change the dynamic of corporate governance that helped to lead us into this financial crisis.